How Venture Capital Lost Its Way

November 19, 2009, 5:00 PM EST

When people around the world try to explain the American system of entrepreneurship, they often point to venture capital. True enough, the venture capital ecosystem has nurtured startups that became household names—among them Apple (AAPL), Cisco (CSCO), Google (GOOG), Microsoft (MSFT), and Starbucks (SBUX). For much of the 1990s and thereafter, venture capital was seen as the "secret sauce" of American entrepreneurship and an engine of job growth. In its heyday in 2000, VC investing reached an astonishing 1.1% of U.S. GDP.

But what if the prominence of venture capital—its branding as the essence of American innovation—turns out to be a phenomenon of the past?

New VC investment, already much lower than in the dot-com days of the 1990s, continues to fall. In 2009's third quarter, VC funds invested $4.8 billion in 637 companies, down 33% from $7.2 billion and 994 businesses a year earlier, according to a report by PricewaterhouseCoopers and the National Venture Capital Assn.

Meanwhile, two areas crucial to American progress cry out for capital-intensive investment: clean energy technology and biotech. And the VC industry isn't delivering it. (Info tech, which by now requires few capital investments, still accounts for the lion's share of those shrinking VC investments.)

What's to blame? We believe today's VC financing model—including the "2 and 20" charged by fund managers (a 2% annual management fee and 20% of all profits made from the IPOs or sales of companies in their portfolios)—no longer works. The industry is at an inflection point: Unless it applies some fresh thinking to the way it structures its funds, it will fail to get the next generation of startups off the ground.

A bit of history may help explain the problem. The modern VC industry started in a partnership format in the 1970s and '80s. Venture funds raised money mostly from wealthy individuals with enough patience for long-term, illiquid investments. Then, as now, investors committed their cash to a fund for 10 years. But because investors were scarce—and wanted to see success stories before plunking down more money—VC funds focused on identifying the right enterprises and sticking with them. Scarce capital made for good VC decisions.

Over the past decade, however, the typical venture fund investor changed. In the era of the financialization of everything, corporate and public pension funds got in the game. VC fund managers found these big investors could commit far more money on the same terms formerly extended to yesterday's high-net-worth individuals. This means a higher volume of continuing management fees. And for many VC managers, that means less focus on startup growth and more on raising funds.

Since institutional investors are under pressure to show short-term returns, VC funds are trying to keep them as investors by going for maximum liquidity, creating early payoffs via premature "exits" (selling some startups in their portfolios within three years, say). Instead of working to make their best startups strong and independent, they're "flipping" them, as private equity firms do with the troubled companies they buy.

In other words, today the traditional VC fee structure promotes haste in putting money to work rather than skill in developing new enterprises (or investing in such capital-intensive niches as cleantech and biotech). Long-term, it doesn't even pay. Over the past decade, an investor would have done better in the small-cap Russell 2000 index than in VC. Indeed, since 1997, returns for the average VC investor have been negative, after fees.

What can be done? In their role as fiduciaries, institutional VC investors should insist that management fees be tied to a budget—office rentals, salaries—not a fund's size. They should also demand a guaranteed percentage on their money, paid out before the VC manager enjoys that 20% share of profits. Both moves might cause VCs to hold on to their best enterprises longer.

So would skin in the game. Today, most VC funds derive a mere 1% to 2% of their totals from partner money. We at the Kauffman Foundation (which has a $1.8 billion endowment it uses to promote entrepreneurship) prefer VC partners who kick in 5% to 10% of their funds' value.

History attests to the importance of capital sources willing to fund unknown companies exploring uncertain innovations. The sooner we revitalize the stale relationship between VC funds and their investors, the sooner the industry can again support America's entrepreneurs.